All deals must be assessed in light of effective rate of interest per year.
You often get calls offering you loans at attractive interests. Some offer you a flat rate of 8 percent for three years and some offer 1.5 percent monthly interest rate. During the festive season in particular, some of us end up overusing our credit cards and such calls seem to provide an escape route. Compared to the 3 percent per month payable on credit cards, these deals may sound like music to the ears. But choosing the right deal is the real issue. Let’s look into the details.
The old wisdom asks us to opt for a like-to-like comparison. All deals must be assessed in the light of effective rate of interest per year. Most home loan offers are expressed this way. So you are not asking the banker for something unheard of. Here is how it works.
Monthly interest rate offers
When you hear the monthly rate of interest you tend to get attracted to it. The biggest hook here is the comparison with the rate of interest payable on credit card. If you have accumulated a good balance on your plastic, then your point of reference is steep 3 percent rate of interest per month. However, do not fall into that mental trap. Do not be a victim of anchoring bias, as they call it in behavioural finance.
When you are out in the market to borrow you need not pay the highest rate of interest. The caller, though, may want to quickly close the sell by offering a ‘small' 1.5 percent rate per month –or half of the 3 percent you would otherwise pay. Do not jump the gun.
“The deal offered by the credit card issuing company need not be the best option. Ask for the interest rate to be expressed in the effective rate of interest per year,” says Anil Rego, founder of Right Horizons. Rate of interest of 1.5 percent per month amounts to 19.56 percent per year. Personal loans are nowadays available at as low as 12 percent.
If you are employed with a blue chip company and have a good credit score then there is a fair chance that you will get better deal in the market. You can also look at a top-up loan just in case the amount is too big and you already have a home loan running.
Flat interest rate offers
The salesperson typically emphasises on the rate of interest but does not speak much about the method. “The flat rate mechanism does not consider charging less interest as the outstanding principal falls over a period of time the way monthly reducing method does. This leads to higher interest payment and higher effective rate of interest for flat rate loans,” explains Vineet Jain, founder and CEO of Mumbai-based LoanStreet.
For the beginners, the monthly rest or monthly reducing interest method calculates interest on the outstanding loan each month. As you start repaying, the principal outstanding keeps falling and so does the interest. Flat rate, however, charges the same amount of interest throughout the tenure of the loan irrespective of the loan outstanding.
When a flat interest deal is offered, the individual eager to close the deal typically compares the rate on offer with the going rate in the market. If the rate on offer is lower than the going rate in the market then there is a tendency to accept the deal. But a reality check will make many decide against it. For example, 8 percent flat rate of interest offered for three years works out to 14.55 percent overall.
Getting effective interest rates will only partly solve your problem. You will have to think about other factors such as prepayment charges and processing fee.
Processing fee is charged as a percentage of the loan availed. The more important information is – this fee can be negotiated. If you have a credit score in excess of 800 or have a long term relationship with the bank, you can ask the bank to waive the processing fee entirely or reduce it.
Prepayment charges are a heavy toll, especially if you are planning to repay the loan much before the due date. Some banks do not allow any prepayment in the first six months of the loan. Prepayment otherwise attract charges to the extent of 3-6 percent. These too can be negotiated.If you are considering a loan just because you are facing a short term cash crunch, then you should be equally focused on these charges as much as the rate of interest. “If you are looking for a credit line for just a month or two, simply opt for a balance transfer to another credit card,” says Anil Rego. This allows you to clear all your debts in a couple of months and you stay out of those high cost personal loans.